Tech Investing: Looking for the Digital Red Flags

WhenHewlett-Packard agreed to buy British software company Autonomyin August last year for $11.1 billion, two well-known investors made diametrically different bets on how the big deal would play out.

To short seller Jim Chanos, who had been raising red flags on Autonomy for years and had started shorting shares of HP in 2011, the deal was another nail in the coffin of the Silicon Valley tech giant, according to a source familiar with his thinking.

But to activist investor Ralph Whitworth, co-founder of Relational Investors, it was time to commit to HP and the turnaround story the company was trying to sell to Wall Street. His fund bought more than 17.5 million HP shares after the deal was announced, and Whitworth received a seat on the company's board. This year, Relational roughly doubled its stake in HP.

In the wake of HP's decision to take an $8.8 billion writedown on the deal because of alleged accounting irregularities at Autonomy, it appears Chanos — whose call to short Enron before the energy company collapsed in a corporate scandal may be his most famous trade — was more astute.

HP's shares are down 36 percent since Relational, which declined to comment, built its stake in the third quarter of 2011.

Fast-Evolving Sector

Relational's big move into HP is a reminder that even smart investors can get things wrong in the fast-evolving technology sector, where once-hot global names like Research In Motion and Yahoocan quickly become yesterday's news.

It is a world in which a company may effectively erect barriers to entry in a market only to have them torn down by a rival with a new whizz-bang product — just as Apple's iPhone broke the dominance that Research In Motion's BlackBerry had enjoyed.

One warning sign that a tech company may be on the verge of losing its edge is when it makes acquisitions outside of its main area of expertise to move into new product lines. Savvy tech investors also counsel wariness of companies that experience a succession of management changes, or when a successful core business starts looking tired.

The pace of change in the technology sector is much faster than in other industries, said Kaushik Roy, an analyst at Hercules Technology Growth Capital. "It attracts new talent and capital, many startups are formed, which can be extremely disruptive to incumbents," Roy said. "In other words, yesterday's winners can rapidly become today's losers and vice versa."

In the case of HP, the company not only has had four CEOs since 1999, it has been striving to find another niche to dominate as demand for one of its core products — computer printers — wanes and as its PC business stumbles.

Or consider online search pioneer Yahoo, which has gone through six chief executives and is struggling to keep pace with Google.

Josh Spencer, a portfolio manager at T. Rowe Price, said frequent turnover in the executive suite at Yahoo was a warning sign to him. Spencer said he does not own Yahoo shares and has not in the recent past.

Red Flags

While a company may view an acquisition as a fresh start — that is what HP was trying to say about Autonomy — some investors see it as a warning the core business is struggling.

Spencer noted that the technology industry's most successful companies — Apple and Samsung— generally have not made acquisitions and instead developed new products internally.

For Margaret Patel, managing director at Wells Capital Management, one of the first red flags she saw at HP was when former CEO Carly Fiorina bought Compaq for roughly $25 billion in 2002.

"I felt then that the acquisition was too large and expensive, and personal computers were not their core strength," said Patel, who has since avoided investing in HP.

Of course, timing can be everything even if an investor is eventually proven right. Patel missed out on a 137 percent gain in HP's stock price from the time of the Compaq deal up until the end of 2010.

Has Apple Lost It?

A few money managers see a flashing yellow light in the big sell-off of Apple shares in the past few months.

Apple, the most valuable U.S. company, has shed nearly 30 percent of its value in the last three months.

Since the death of co-founder Steve Jobs — the driving force behind Apple's iPod, iPhone and iPad — DoubleLine co-founder Jeffrey Gundlach has been recommending that investors short the company's shares because "the product innovator isn't there anymore."

Gundlach said he began shorting Apple's stock at around $610 and maintains that it could drop to $425. He declined to comment on Tim Cook, who succeeded Jobs over a year ago and is seen by many as less visionary and innovative than Jobs.

Christian Bertelsen, chief investment officer at Global Financial Private Capital, with assets under management of $1.7 billion, said his firm began paring back its exposure to Apple this fall because he felt the expectations for the company's new iPhone 5 had gotten overheated.

He said his firm dramatically took down its exposure to Apple shares when the stock hit $670 a share. "For us, the light bulb went off this fall," he said. Mind you, Apple's shares still remain up about 25 percent for the whole year.

And then there's Research In Motion. Once a leader in smartphones, it's now in danger of becoming irrelevant.

"They saw the move towards all touchscreen phones and didn't move with it," said Stuart Jeffrey, an analyst at Nomura Securities who noted how the BlackBerry 10 touchscreen phone will debut on Jan. 30, 2013, six years after Apple released its first iPhone in 2007.

Robert Stimpson, a portfolio manager at Oak Associates Funds whose fund does not own any shares of Research in Motion, said the company's BlackBerry phones are on a downward slope and it will be tough for the company to regain its lost luster.

"The end of the road is a long, lonely journey," Stimpson said of Research In Motion. "I think they will fight the good fight for many years, probably unsuccessfully."